For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

All investing is subject to risk, including the possible loss of the money you invest.

I am a fan of movie trilogies, and my favorites include those that involve Luke Skywalker and Jason Bourne. Trilogies interest me because, while they consist of separate movies, they still share an overarching story line. That’s not dissimilar from three separate investment strategies that share an overarching goal of generating income. Those strategies—overweighting corporate bonds, substituting dividend-paying stocks for bonds, and executing a duration tilt—are what could be referred to as The Search for Yield trilogy.

While generating income in today’s low-yield environment is a challenge, Vanguard Chief Economist Joe Davis recently discussed the reach for yield as one of his areas of concern. When we review each movie (strategy) in The Search for Yield trilogy, viewers (investors) will note that each is characterized by the trade-off between return and risk.

Overweighting corporate bonds

Many investors have allocated a larger portion of assets to corporate bonds, including those that are rated below investment grade. This type of strategy is likely to provide investors with higher yields relative to Treasuries over the long term. However, much like Frodo Baggins, some investors may not be fully aware of the risks these decisions entail. Investors may enjoy the benefits of more income, but higher yields are intended to compensate investors for the additional risks, namely default risk. The figure below shows that the current level of compensation investors receive for taking default risk seems a bit on the low end of the historical range. However, as I have noted before, credit risk should also be viewed in the context of equity risk. We like to remind investors of both of these risks because taking the blue pill could lead to a world that doesn’t fully describe them.

Substituting dividend-paying stocks for bonds

A good way to better understand dividend-paying stocks is to go back to the future … or at least back to a blog Joe Davis wrote in 2011. Even then, Joe was highlighting the risks associated with filling a portfolio’s bond capacitor with dividend-paying stocks. While dividend-paying stocks may provide solid income and greater capital gains relative to bonds in low–interest rate environments, investors should consider whether this is worth the increase in volatility. The magnitude of loss for stocks is several multiples greater than that of investment-grade bonds. The figure below illustrates why even dividend-paying stocks are not immune to equity risk. They are not suitable substitutes for bonds because, after all, they are still stocks … much as no matter how human the T-1000 looked, at the end of the day, it was still a machine.

Executing a duration tilt

Investors seem to be treating longer-duration tilts as movie buffs do the third Godfather—they pretend it doesn’t exist. For several years now, investors have shied away from longer-term bonds for fear of rising rates. Their fears are valid. If long-term and short-term interest rates were to rise by the same amount, long-term bonds would suffer greater capital losses. But this typically doesn’t happen, because most interest rate movements are not parallel shifts of the yield curve. Vanguard’s base-case scenario in the current environment is for a bear flattening of the yield curve, wherein shorter-term rates rise more than longer-term rates. Of course, we can’t tell with certainty that this will occur. The figure below shows that the compensation for extending duration is currently higher than it has been historically. Investors who tilt toward short duration bear the risk of forgoing the additional yield; investors who tilt toward long duration bear the risk of relatively higher volatility. Either choice comes with a form of risk. In his quest for archaeological returns, Henry Jones Jr. seemed to face risks with every choice too.

None of this suggests we advocate for overweighting corporate bonds, substituting dividend-paying stocks for bonds, or executing a long-duration tilt to generate income. (We do advocate for total-return investing, though.) We only point out that each of the strategies in The Search for Yield trilogy is characterized by the trade-off regarding return and risk. In investing, the enduring nature of that trade-off tends to die hard.

I would like to thank the rest of the trio for their contributions to this blog: my colleagues Andrew Patterson and Ravi Tolani.

Jim Rowley

Jim is a senior investment strategist in Vanguard Investment Strategy Group, where he leads a global team that's responsible for conducting research and providing thought leadership on indexing and exchange-traded funds (ETFs). Jim’s research paper, "The ins and outs of indexing tracking," was published in The Journal of Portfolio Management. Before joining Vanguard, he worked at Gartmore Global Investments, Lehman Brothers, and Merrill Lynch. Jim earned a B.S. from Villanova University and an M.B.A. from New York University. He is a CFA® charterholder and a past president of the CFA Society of Philadelphia.

Comments

Bob M. | March 5, 2015 1:33 pm

George G. | March 6, 2015 9:06 pm

Yes, and the same strategy could work with bonds, yes?
Let’s say one has a certain sum in investment assets and wishes to generate approx. 5% per year in income. Don’t care about the net asset value of anything, never going to sell, just want to get that income. Why not put, say, 80% in a high yield corporate bond mutual fund that has been around for more than 30 years and the rest in a bond market index fund? Let’s also assume there are other cash assets in the portfolio to hedge all this. Comments?

Richard A. | January 29, 2015 2:44 pm

As a current student of descriptive statistics, I am disappointed in the in the information given to understand what is being plotted in the box plots. For example, please define the high yield spread and the term spread. Describe what the percentage values on the y-axis refer are a percentage of or whether they are interest rate values. The data in the two graphs also are for very different time periods with no explanation as to why. Finally, a link to the study describing methodologies for those that are interested would be greatly appreciated.

Richard, thanks for your interest in the data; I will be glad to address your concerns around statistical definitions. First, high-yield spread is represented by the option-adjusted spread of the Barclays High Yield Index, and term spread is represented by the difference between the 10-year Treasury yield and the 3-month Treasury bill yield. Second, the y-axis values are interest rate values. Third, the time periods are different because of data availability. Finally, the box plots are built based on the monthly data points for each option-adjusted spread and term spread.

Carl S. | January 29, 2015 1:10 pm

1. Referring to the graph of total return of dividend paying stocks versus all U.S. stocks, the dividend paying stocks had a greater percentage loss in 2008/2009 than the overall stock market, even though their standard deviation of annual returns over the 16 years shown has been slightly less. From this, I regard dividend paying stocks to be “riskier” in the sense of being more susceptible to MAJOR market declines.
2. A similar graphical analysis of the total return of Vanguard’s High Yield Corporate (bond) Fund compared to the Wellington and Wellesley balanced funds (which anybody can do by clicking on the “Price & Performance” tab of the page of any of these on Vanguard’s website) demonstrates that the performance characteristics of all 3 funds are very similar and conform to the efficient-markets principle that greater risk is associated with greater long-term return.

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For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss.

Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.

All investing is subject to risk, including the possible loss of the money you invest.